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Conquer complexity: Get briefed on the latest accounting updates

In the accounting world, the rules are ever changing. Large in scope and long awaited, the new rule for recognizing revenue continues to get clarifications in the months leading up to its effective date. The new leasing standard is finally here as well and sharing the attention. Those are just the biggies—the Financial Accounting Standards Board has been coming out with a flurry of changes in recent months, and regulators are paying attention to what you are doing with them. There’s a ton of information to follow to stay compliant.

How equipped finance teams are to keep up with all the moving parts varies quite a bit. They oftentimes find it beneficial to lean on technical accounting experts who can decipher the never-ending landscape and help with interpretations. Such experts can help them stay on track in understanding the latest accounting refinements, transition-method choices and effective dates. Diana Gilbert, senior consultant at RoseRyan and head of our Technical Accounting Group, helped many companies get up to speed during the June 2 webinar, “Demystifying the Latest Major Accounting Changes.”

This fast moving, 90-minute, all-out binge covered the latest twists and turns that have come out from FASB and regulators over the past year. Some changes have simplified things. Others will have a narrow effect. And many will force finance teams to do some soul searching as the deadlines near. Contracts and compensation plans may need to be revisited.

Diana filled in listeners (most of whom were from life sciences and technology companies) on the five topics below, along with other changes, and gave timely advice along the way.

Revenue recognition: Companies that don’t have a game plan for the new revenue recognition standard are running out of excuses. The SEC has been “aggressively” referencing the new rule in recent speeches to let companies know they will be watching what gets said in disclosures, Diana said. Boilerplate, vague language won’t cut it much longer.

“This has been out there since 2014, so they are going to question why you’re still evaluating it now,” she said. “If you’re honestly, sincerely evaluating it, then just be prepared for the questions. But if you’ve done your evaluation and pretty much do understand the impact, then think about including more detailed disclosures, particularly about decisions you’ve already made,” such as the transition method the company will be taking and the planned adoption date.

Leases: The new standard finalized in February will bring what we refer to as operating leases today onto the balance sheet. The rule applies to leases of property and equipment with terms of at least one year and centers around the lessee’s “right of use” of an item (the obligation to pay for that right is what will appear on the liability side of the balance sheet).

The new rule could change behavior, Diana predicted. “Think about it. If you’re going to have it on the balance sheet anyway, are you still going to lease it or would you buy it outright?” she said. “You might create new forms of leases that are clearly less than a year, without the option to renew, and you’ll have to deal with the issue every year. That may make sense for inconsequential arrangements. It will be interesting to see what happens going forward.”

Financial instruments: Public companies will begin following new rules on classifying and measuring financial instruments for filings submitted in 2018, and private companies will do so a year later. Equity investments that are not consolidated are generally going to be measured at fair value through earnings. In some ways, disclosure requirements have been simplified with the rule changes—companies won’t have to disclose their methods and significant assumptions for estimating fair value—and in other ways they have expanded.

Stock-based compensation: Companies have “a grocery bag of different changes” to deal with when it comes to improvements to employee share-based payment accounting, Diana warned. The most significant relates to deferred tax assets. When the changes take effect, companies will no longer record excess tax benefits and certain tax deficiencies resulting from share-based awards in additional paid-in capital (APIC). APIC pools are eliminated under the changes.

Diana said this is a “huge simplification” in terms of tracking share-based compensation, but the downside is the potential for more volatility in the income statement. This particular change is applied prospectively from the date of adoption (which begins after December 15, 2016, for public companies).

SEC comments: The SEC staff has always tended to question areas that involve judgment and subjectivity, Diana noted. In recent years, in particular, they have been scrutinizing the statement of cash flows and whether companies’ internal controls are effective. Diana recommended that companies be as clear as possible and use tables and charts to help tell their story.

“Comment letters come about because they don’t understand what’s happening,” Diana said. “Or it’s a complex area and they’re going to ask you questions whether you like it or not.”

Keeping tabs on regulators’ areas of emphasis and accounting standard-setters’ changes takes time and effort. Things are in constant motion, and companies need to stay on top of it all. That’s how they can help minimize the questions that come from regulators and any uncertainty that may arise during implementation. To save time and effort in understanding the latest accounting standards (changes through June 1, 2016), feel free to check out the 90-minute replay of “Demystifying the Latest Major Accounting Changes” here.

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Non-GAAP measures: Do they provide helpful insights or hide the “bad stuff”?

Many companies, especially in tech, supplement their income statement produced under generally accepted accounting principles with a non-GAAP income statement. It’s a practice that has proliferated in recent years as companies want to focus attention on the underlying “run rate” of the business and feel pressured to copy what their competitors are doing. Critics label non-GAAP measures as companies presenting “income before the bad stuff.” It’s true that presenting financials on a non-GAAP basis often has a major impact on the bottom line presented, by doubling a profit margin or turning a loss into a profit (as shown in our chart below).

Does non-GAAP reporting mean a company is hiding poor performance? Or is it providing investors with more information for judging the health of the business?

On balance, more disclosure is usually better. When companies present non-GAAP income statements in a thoughtful way and in good faith, investors will usually prefer the additional information and use the non-GAAP income to calculate P/E valuations. Note that most investment analysts report and focus on non-GAAP results. And the Securities and Exchange Commission has accepted their use as well, as long as the information is not misleading. The regulator outlines how and when companies can share non-GAAP figures with Regulation G.

So non-GAAP income statements look like they are here to stay. Let’s look at the most common areas where companies adjust GAAP numbers to give non-GAAP measures and why such measures have become accepted by both companies and investors.

Stock compensation: These are charges based on employee stock options and purchases that rely on theoretical models of their worth. Probably the most commonly listed adjustment to GAAP numbers, this charge is a lightning rod for criticism that GAAP has become overly conceptual and less relevant. As my colleague Stephen Ambler points out in his blog post “Stock compensation rules mask true operating performance,” stock comp charges are non-cash and can vary significantly depending on stock price and model assumptions, making it near impossible to compare two similar companies. Also, if the stock price declines, the company must continue recording the charges, which were based on the grant date value, even though the options have no value to the employees or to the company from a retention point of view.

Amortization of acquired intangibles: GAAP accounting for acquisitions requires the acquiring company to value the intangible assets of the acquired entity, other than goodwill, at fair value and amortize them over their useful lives. On one hand, the acquiring company paid hard cash or used its valuable stock to acquire these assets, and just as companies depreciate the purchase price of equipment they use in production under GAAP, they also should amortize their acquired intangible assets. They are matching cost with use over time. On the other hand, the amortization is a non-cash charge that the acquired business wouldn’t have shown on its own. To assess the sum of the underlying businesses, it is useful to show amortization removed.

Restructuring: These charges include such items as severance, facility and equipment write-offs, and contract termination costs tied to the resizing or closing of some part of a business. CFOs would prefer to keep the costs of these non-recurring events separate from the ongoing business’s results. Companies do need to be careful, though, that these “non-recurring” charges don’t recur every year or two! To mitigate abuse, Reg G sets rules for what is non-recurring — basically, it is something that hasn’t happened two years before the reporting date and is unlikely to happen in the next two years.

We commonly see the non-GAAP income statement remove other measures as well, such as the amounts paid to plaintiffs and attorneys to settle legal disputes or impairments of intangible assets or goodwill. Again, the rationale is to derive an income number that represents the fundamental ongoing business apart from non-cash charges and one-time events. The value to the investor is that these items are shown separately. The investor can value the company on its ongoing business while noting the size and frequency of these non-cash and non-operating charges.

To GAAP or to non-GAAP?
While investors are open and usually welcoming to non-GAAP income statements, they also value consistency. Companies should not use “good news” non-GAAP items and ignore “bad news.” Consider a company that accrues $1 million for a legal settlement and excludes the charge as a non-GAAP measure. It has effectively created a good news item. But if the actual settlement in a subsequent period turns out to be only $800,000, the company should include the $200,000 difference as a non-GAAP item when it comes time to report it. This difference may be perceived as bad news, but this keeps reporting consistent.

In general, companies should use an approach that relies on both full disclosure and moderation. Reg. G requires full disclosure, of course, including a presentation of the most directly comparable GAAP measure with equal or greater prominence as the non-GAAP measure, as well as reconciliation between the two. As for moderation, the investment community will reward companies that practice it, as moderate, thoughtful use of a non-GAAP income statement will build credibility and respect for the company. Finance pros who do these types of evaluations all the time can help you determine when applying non-GAAP makes sense for a particular situation.

Ray Solari is a member of the RoseRyan dream team. He has served as the CFO/VP finance for private companies and managed SEC reporting for public companies. He began his career at Deloitte. 

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Equity compensation: 4 hard truths you need to know

Equity-based compensation — Northern California’s universal answer to engendering loyalty in employees — is a useful tool but a complicated one. This was one of several hard truths heard by attendees during BayBio’s recent Lunch & Learn event by RoseRyan. Accompanied by compensation consultancy Radford, RoseRyan hosted this packed event on February 26 at BayBio’s headquarters in San Francisco.

To retain top talent these days, companies have a variety of stock-based methods, which are accompanied by their share of accounting, tax, and legal issues. What strategy a company picks today for rewarding employees could affect how smoothly it can transition to another version of itself later on, either as a public entity or as an acquisition target.

During their comprehensive overview of what private companies need to realize as they structure and maintain their comp plans, Kelley Wall, a director at RoseRyan who leads the firm’s Technical Accounting Group, and Kyle Holm, an associate partner at Radford, hit upon the following hard truths.

1. Your company will have to up the ante as it matures.
Startups tend to begin with just stock options and then work their way up to restricted stock or restricted stock units and eventually performance-based awards. Each compensation type comes with its own set of pros and cons. For example, stock options do not lead to immediate dilution whereas restricted stock does. Employees may favor restricted stock for the fact it will give them ownership right away, but tax consequences upon vesting can be troublesome.

And while performance awards encourage goal-based behavior, they are not without their challenges. With these type of awards, companies have to regularly determine the probability of employees meeting their performance targets and adjust their stock-compensation expense accordingly, which can create some volatility in earnings. And it may be difficult for early-stage companies to adequately assess performance targets — any modifications of those targets down the road will result in modification accounting and likely additional compensation expense.

2. Modifications can be messy.
Modifications will happen. The roles of employees change, employees come and go, and employees’ individual targets for reaping the benefits of a pay plan will evolve. And so will the way the company accounts for compensation. Situations where accounting changes come into play include: giving a terminated employee an extended period to exercise their options beyond what was initially agreed upon; changing performance-based metrics; and hiring consultants and allowing them to continue to hold the stock options they were granted as consultants. In general, any change to an award or an award holder’s status should trigger a review of accounting modifications.

3. Your payment systems are only as accurate as the data you’ve put into them.
Wall acknowledged this truth seems fairly obvious but cautioned that lack of data integrity continues to trip up companies. Too often companies lean too heavily on outside lawyers and accountants without realizing those service providers can’t keep up with changes within a business if they don’t know about them.

The fact is the majority of stock-based compensation data has some underlying issues. For instance, RoseRyan has seen a company with vesting stock options for employees who left five years ago — which led to an overstatement when the information was uncovered. To make sure the data surrounding their equity plans are clean, companies need a system of checks and balances — such as reconciling awards granted with board minutes at least once a quarter and having a process to tie employee terminations to the equity records.

4. You have a lot to consider about your equity plans if an IPO is in your future.
One of the hardest truths hits in the time leading up to a public offering. This is when tough questions arise over all the decisions that have been made beforehand, Holm warned, and even more difficult choices will need to be made. Those who have a stake in the company will shift their focus from their percentage of ownership to the actual value of their shares. Companies going through the transition will need to determine whether they should consider amending their stock plans. They’ll also need to define their post-IPO equity pool size. And they’ll need to take a look at how they communicate beyond one-on-one pay agreements. It’s also a good time to consider what information will be publicly disclosed in your registration statement. For one, details about pay plans for the most highly paid senior leaders will be publicized, not only to investors and securities regulators but employees as well. There’s also a lot of information regarding the plans and award details included in SEC filings, and newly-public companies are burdened with additional disclosures around stock valuation.

While equity-based compensation comes with issues, Wall noted, managers can provide robust pay plans that do what they’re supposed to — retain top talent — as long as they operate with their eyes wide open with an awareness of how changes and new decisions will have consequences.

This post originally appeared here, on BayBio’s website.

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3 quick tips for streamlining your stock-based pay plans

Keep your employees motivated with stock-based compensation, the thinking goes, and you will be rewarded with high productivity and gains in your company’s growth track. What managers often fail to consider is that if they make mistakes along the way—and we’ve seen many when it comes to equity-based compensation plans—they could actually end up with low employee morale, putting a crimp in the pace of the performance-aligned goals they have set up.

Whenever a company has to amend awards previously made or restate their financial statements because of adjustments in equity-based comp, employees will naturally have concerns—even when the change has little, if any, financial impact on them.

The risk of dents in morale is just one of many consequences RoseRyan has observed while helping clients with issues in their equity-based pay strategies. You’d be amazed at the range of problems we have seen—many of them due to honest mistakes. In our experience, 9 out of 10 companies have had some issue with their underlying stock data that affects their stock-based compensation expense.

To prevent such problems at your company, consider these three tips the next time you evaluate your stock-based compensation strategy (we’ll get into more detail about this topic at our February 26 luncheon called Compensation for Private Companies: The Ins and Outs of Equity, which will be held at BayBio with Kyle Holm, associate partner at compensation consulting firm Radford).

Be obsessive about looking for modifications: Some modifications are obvious (say, repricing a stock option); some modifications are less so (say, allowing a consultant to keep options after you hire that person as an employee). Keep an eye out not only for board decisions but also for management decisions, material transactions, and liquidity events. The rule is, any change to the award or the award holder’s status should trigger consideration of accounting modifications.

Identifying that you have a modification is just the first challenge; the accounting can be tricky as well. How you account for the modification will depend on the type of modification. Variations include measuring the incremental value only, accelerating the expense, or valuing the new award and reversing the value associated with the original award. You also need to be sure you’re entering the modification in your equity system in a way that captures the appropriate modification accounting.

Make sure performance-based awards are on everyone’s radar: Performance-based awards are great tools for both retaining employees and motivating goal-driven behavior. But there is accounting risk here as well. With performance-based awards, companies must assess the probability of achieving the metrics at each reporting date and adjust the expense accordingly. This step often doesn’t happen. Maybe the board minutes lay out the performance goals associated with an award, but the stock administrator gets only a spreadsheet of grants to administer, with no indication that vesting is contingent. Or maybe the stock administrator is aware of the performance targets but doesn’t flag performance-based grants in the equity system, so the accounting team doesn’t know they exist. Such miscommunication can lead to overstated stock-based compensation expense.

Tie your 409A valuations to major grant dates: For private companies, the rule of thumb is to obtain a 409A valuation of your stock at least once a year, and in conjunction with major events such as financings, significant transactions, or material changes to the business. Some companies instead tend to do their 409A at the end of the year, just because they’re doing other valuations and financial decompressions at the same time. But think about this example, from one of our clients that approved a major grant to executives and employees in June 2011, six months after valuing its common stock at $1.25 per share for its annual 409A. By that point, the value of the stock had increased significantly—to $3—based on several design wins and other economic factors. While that’s a nice problem to have, they suddenly faced additional stock-based compensation expense and time-consuming updates to their equity system, among other issues.

It’s easy to think your equity-based compensation is under control; however, we have found time and again that it’s an ever-evolving tool that needs tending to, as your headcount grows, the complexity of your company expands, and situations evolve.

Get in the mode of reevaluating your pay strategy during the RoseRyan February 26 Lunch & Learn seminar about equity in South San Francisco. It will be geared toward private companies. Click here to register. And for more details about these best practices as well as some others to consider, also check out the RoseRyan intelligence report I wrote called Stock options: do you have a problem?.

Kelley Wall leads RoseRyan’s Technical Accounting Group, which provides technical accounting and SEC expertise to public and private companies on complex accounting matters and implementation of new accounting pronouncements. 

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Making a list and checking it twice

The holidays are fast approaching, and with them, all the stress of the season. Santa is making his list and checking it twice, and we accountants can follow his lead to keep a little sanity in our 2012 closeout activities.

Here’s my recommended year-end to-do list:

Account reconciliations—Yes, ideally these were performed on a monthly basis, but if other priorities shunted them aside, now is the time to get them done. And it’s a good idea to review all your current reconciliations to see if any items need resolving before you ring in the new year.

Impairment analysis—Have you attempted to identify indicators that might affect your asset valuation? Have you documented your findings in an accounting memo for your records? No? Get on it!

Inventory of non-routine business transactions with accounting or disclosure implications—If you haven’t already, prepare an accounting memo summarizing each of these transactions, and for each, outline the accounting policy and its basis in GAAP. It’s best to prepare these memos close to the time of the transaction, while the information is readily available and the details are fresh in your mind, but if other demands took precedence, catch up—before you close your books and invite your auditors in.

Revenue recognition—Have you been keeping good documentation for large or unusual transactions? If not, now’s the time to tackle this task. Review your revenue transactions and make sure you have a well-written accounting memo documenting the basis in GAAP for your revenue recognition conclusions. Also, make sure you have copies of the relevant contract or other pertinent information. Is VSOE important to your revenue recognition policy? If so, ensure that you have maintained it by updating or testing it.

SOX annual controls—By definition, these controls are performed once a year. Take a look through your SOX documentation and make sure you have a complete list of everything you need to do. It’s easy for something to fall through the cracks. Speaking of which, do you have SOC 1 reports from all your in-scope third-party providers? Have you reviewed and evaluated them for any adverse impact on your internal controls?

Stock-based compensation accounting—Let’s be blunt: this task is a hotbed of opportunity for things to go awry. If you haven’t been through your equity records with a fine-tooth comb in a while, examine them now. Problems we commonly find range from data entry errors to missing or incomplete paperwork, surprise (at least to the accounting department) option modifications, and unsupported Black-Scholes assumptions. Check out our guide, Stock Options: Do You Have a Problem?, to avoid these and related pitfalls.

This list should help you stay on track for a smooth year-end close. Happy holidays!

 

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Year-end heads-up: don’t let equity issues take you by surprise at audit time

December 31 is fast approaching. Can audits be far behind? Every year as we help our clients maneuver through the audit process, it seems that one of the areas that can cause significant difficulties is equity. It’s not so much the basics, like recording the issuance of 5 million shares of Series C preferred at $3 a share, or the exercise of a stock option, but the “little” issues that don’t pop up until the financial statements are actually being prepared and the footnote disclosures drafted. Things like stock option modifications (that’s a modification?!), accounting for nonemployee options (what do we remeasure and when?), common stock valuations (we did a 409A valuation in October; why do we need another?) and warrants (what do you mean, the warrants are liabilities?). Let’s take a closer look at these issues.

Stock option modifications

Everyone recognizes that a stock option repricing is an option modification. But a lot of other transactions are also considered modifications—and as such have accounting consequences—including extending the post-termination exercise period; exchanging stock options for other types of awards, such as restricted stock units; and changing the option holder’s status from consultant to employee (or vice versa). Altering the vesting terms of an option or other award can also trigger accounting ramifications. In some cases, only the timing of the expense may be affected. In other cases, including accelerating vesting at termination or changing performance criteria, the value of the option must be remeasured, and additional expense may result.

Accounting for nonemployee options

In general, the measurement date for a nonemployee option is the vest date, not the grant date. So technically, you should remeasure nonemployee options on each vesting date, which can be a rather daunting task if your options vest monthly. Fortunately, most auditors are okay with quarterly remeasurement. However, if you are calculating all remeasurements at year’s end, you may discover unexpected issues related to common stock valuations (see below). Also keep in mind that not all software is created equal when it comes to managing nonemployee stock options. Testing your system by manually recalculating expense for a sample of nonemployee options is always a good practice.

Another thing to remember: once each option tranche has vested, the vested shares are no longer subject to remeasurement. We occasionally see situations in which a company has continued to remeasure all shares until the option is fully vested. This practice misstates expense, frequently overstating it.

Common stock valuations

How often do you really need to have a common stock valuation, also referred to as a 409A valuation, performed? The answer is one of those very definite “it depends.” If your company is relatively stable, an annual valuation may be sufficient for both tax and accounting purposes. But if your company is dynamic and reaching significant milestones, you will likely need 409A valuations more frequently. Let’s say you closed your Series C round in September and had a 409A valuation performed in conjunction with that event. In December, your company achieved a significant milestone, like introducing a new product or receiving a favorable result on its Phase III trial. The December milestone increased your company’s value and likely requires a new 409A valuation. Performing the valuation contemporaneously and proactively is best. Dealing with it when your auditors request it usually adds significant time to the audit and could add to the cost of the valuation if the valuation firm has to expedite its work to meet your timelines.

Warrants

Warrants could easily be the subject of an entire article, but here are a few things to be aware of for now. Companies frequently issue warrants for preferred or common stock in connection with debt agreements (bridge loans, term loans, lease lines, and so on) or equity offerings. In all cases, the proceeds that the company receives must be allocated between the warrants and the base loan or equity offering. If the warrants are for preferred shares and there’s any possibility your company will redeem the underlying preferred shares for cash, the warrants are considered liability instruments and must be revalued at each balance sheet date with the change in value flowing through the statement of operations. In addition, if the base loan is convertible into equity, as is generally the case with bridge loans, the warrant will usually create a beneficial conversion feature because of the allocation of a portion of the proceeds to the warrant. Addressing these situations can be confusing and time consuming. Best practice is to discuss them with your accounting advisors before actually sealing the deal so that any accounting issues can be addressed up front.

Wrap up

Before you say good-bye to 2012, do two things. First, review your equity transactions, stock option records, board minutes and other relevant documents to determine whether any of the transactions or situations I’ve described occurred during the year. Then discuss your findings with your accounting advisors, equity service providers or both to ensure that the proper accounting treatment has been applied. You will certainly be better prepared for your audit, and you may save yourself from some significant headaches and maybe even some audit fees.

 

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New report: sober up your equity compensation accounting

Stock options in Silicon Valley are like free drinks in Las Vegas—and accounting for equity-based compensation often gets treated with the breezy inattention of a gambler ordering another round. But eventually some kind of tab will come due. Think company money and time, restatements and increased auditors’ scrutiny.

Our new report, Stock Options: Do You Have a Problem? by Kelley Wall of RoseRyan’s Technical Accounting Group walks you through the issues we see regularly and tells you how to get clean.

Don’t think this applies to you? Equity-related restatements most often stem from honest mistakes—and they’re more common than you might think. Why? Some companies aren’t fully aware of accounting requirements. Others have incomplete or broken internal processes. And some rely on equity systems with parameters and limitations they don’t really understand.

Let’s take one example. Stock-based awards to employees and nonemployees are accounted for differently. No big deal—but the problem we’ve observed is that companies fail to identify nonemployee recipients as nonemployees. Perhaps the stock administrator assumes all the grantees on a list of option grants are employees. Or the equity administrator doesn’t set up the system to identify both the individual and the grant as nonemployee. Or the accounting department doesn’t realize there are nonemployee awards, so it doesn’t ask for nonemployee stock-based compensation expense reports. In each case, the result is an understatement of expense.

You can avoid this and many other costly accounting mistakes by adopting our recommended best practices in the areas of communication, valuation, modifications/special arrangements and forfeiture rate estimation.

Don’t become yet another sobering example of a painful accounting breakdown. Check out our report to ensure that your equity compensation practices are up to snuff.

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Will your equity compensation strategy take you from start-up to exit?

RoseRyan, along with the Melita Group, is presenting a free breakfast seminar, “Equity compensation: end-to-end strategies for private companies,” on October 30 in Palo Alto.

Your equity compensation plan’s design and execution affects your ability to retain employees, your readiness for exit and your market valuation, as well as other areas of the business. How do you set yourself up for success? If you don’t have an equity compensation plan for an M&A deal or IPO, now is the time to develop one.

“Equity compensation: end-to-end strategies for private companies,” will give you tips on:

  • Real-world (not pie-in-the-sky) equity comp strategies
  • Choosing the right equity comp vehicles
  • Avoiding common stock comp pitfalls
  • Preparing for—and making the most of—a liquidity event

For this seminar, we tapped some of the Bay Area’s savviest equity experts.

Alexander Cwirko-Godycki, senior manager, Radford: Alex supports Radford’s compensation consulting practice by creating new intellectual property and data-driven content. He is co-creator of Radford’s pre-IPO/venture-backed company online portal.

Kelley Wall, Technical Accounting Group, RoseRyan: Kelley leads RoseRyan’s Technical Accounting Group, advising clients on complex accounting matters and assisting with strategic business transactions such as IPOs, mergers and acquisitions, joint ventures and divestitures.

Ellen Sueda, senior counsel, Seyfarth Shaw LLP: Ellen works in Seyfarth Shaw’s Employee Benefits and Executive Compensation department, advising employers on tax, securities and employment law matters.

Carrie Kovac, director of finance, Symantec: Carrie is responsible for all company operations related to equity, including ASC 718, SOX, SEC reporting, global stock programs and the annual proxy statement.

The seminar takes place 8–10 a.m. at the Westin Palo Alto in Palo Alto. Get details and register here.

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Bucking tradition: is stock-based comp expense a worthy performance measure for Facebook?

U.S. accounting standards require companies to recognize expense based on the fair value of the stock-based compensation awards issued to employees; most commonly these are stock options and restricted stock units. Some know this accounting standard as Financial Accounting Standard (FAS) 123R, now referred to as Accounting Standards Codification (ASC) 718.

Most companies adopted this standard in 2006 and concurrently decided to exclude stock-based compensation expense from their financial statements when reporting their results to investors in earnings releases. Why? The most common reasons were that the charges were noncash in nature and that they believed excluding these amounts made their financial statements more comparable period-over-period and more comparable with other companies’ financial statements.

Now Facebook’s situation is calling this tradition into question.

In an article released Sept. 22, Barron’s questions the value of Facebook stock and criticizes the company for excluding stock-based compensation expense from its adjusted earnings. “This dubious approach to calculating profits is based on the idea that only cash expenses matter,” writes Andrew Bary. “That’s a fiction, pure and simple.” (Read “Still Too Pricey” online.)

Facebook, however, believes that by excluding these costs they are providing meaningful supplemental information to investors. In Facebook’s earnings release for the second quarter of 2012, it’s explained that “varying available valuation methodologies, subjective assumptions and the variety of award types that companies can use” can cause incomparability between Facebook and the competition. The earnings release also references the $1 billion expense, which was technically granted and earned over several years, that Facebook recognized in their first quarter as a public company.

Ironically, the top two reasons the Financial Accounting Standards Board (FASB) issued its fair-value accounting guidance were 1) to address concerns from financial statements users, including institutional and individual investors, regarding the faithful representation of compensation expense; and 2) to improve the comparability of reported financial information.

Here’s the big question: is stock-based compensation expense really a meaningful measure of a company’s operating performance? Both Google and Apple would join Facebook in saying it isn’t. I can see arguments for both sides, but it’s not about what I believe: it’s up to investors to draw their own conclusions. While companies like Facebook (technology companies especially) generally exclude stock-based compensation expense from their reported non-GAAP earnings, they are also required to provide disclosures, including the amounts excluded and the basis for excluding the charges. So, if you believe that Facebook shouldn’t have excluded $1.1 billion of stock-based compensation expense from its reported $1.9 billion of total operating expenses for the second quarter of 2012, or the $2.2 billion of unrecognized stock-based compensation expense as of June 30, 2012 that it expects to recognize over the next two years, then add it back in. It’s a calculation, not a conspiracy.

For another look at stock compensation, see RoseRyan guru Stephen Ambler’s “Stock compensation rules mask true operating performance.”

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Equity compensation: the devil is in the details

Equity compensation can be a significant factor in attracting and retaining talent. Lately a lot of attention is being given to effective compensation strategy, investor expectations and shareholder dilution. Philosophies have evolved and rules and regulations have changed, but one thing that remains constant is there are often surprises in the accounting for stock awards. We see start-up companies struggling to get the accounting right, and we see struggles in public companies with well-designed internal control systems, too.

What not to do

Many of these challenges can be avoided simply by paying attention to the details. Getting the paperwork right sounds easy, but you’d be surprised at what can happen. Here are a few of the most common errors to be on the lookout for:

  • The number of shares to be granted is a mystery, because the number of shares in the grant paperwork doesn’t agree with the number of shares approved in the board minutes.
  • There is confusion over when the employee started work. It’s not uncommon for employment start dates to be revised between the time the offer letter is sent out and the day the employee actually shows up. Granting stock to someone before they are an employee can cause problems; the accounting for option grants to employees is different than the accounting for option grants to nonemployees. And some stock plans prohibit granting options to nonemployees.
  • Stock is granted without proper approval. Understand (and communicate) who is authorized to grant stock or options. Having a clear stock grant policy is critical—as is making sure people understand it and follow it.

We also see data entry errors, which include:

  • Grant date or option strike price are entered incorrectly.
  • Vesting schedules are entered incorrectly (for example, a grant is entered as vesting ratably over four years instead of having a one-year cliff).
  • The grant is not input or is input twice.
  • Paperwork is not processed on a timely basis. This applies to inputting new grants as well as cancelling grants for terminated employees.

Keep accounting in the loop

Reconciliations are your friend. Make sure to reconcile your stock records to the transfer agent records as part of your monthly close process. Compare new hire listings to stock grant records, and termination listings to stock cancellation records. Double-check data input to source documents.

Modifications can have major accounting implications, including significant current P&L expense. Oftentimes companies make decisions about stock option modifications without considering the accounting implications. A good practice is to have your accounting department analyze modifications and compute the potential P&L impact before a decision is made. The stock options may still be modified because that makes business sense, but everyone will understand the amount of the additional expense before the modifications are approved.

And remember: a stock option grant modification is any change to the terms after the stock is granted; these include changing the number of granted shares, altering vesting terms and repricing options. (It’s not unusual for a CEO to agree to modifications with a terminating executive without discussing it with accounting—and that can result in huge P&L impacts that could have been prevented.)

Because stock is part of employee compensation, errors are a double whammy. They can have a significant impact on employee morale and motivation, for example, if employees don’t get what they thought they were getting, or if a grant has significant tax implications for them. Errors can also impact the company financially because incorrect data can affect the computation of stock-based compensation expense.

The good news is these problems can be avoided with education, discipline and communication. A good place to start is our upcoming seminar at the end of October.

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